The Prius Economy

The first inklings of the scare may have come from China, a week or two ago,
or perhaps from Spain as the 10-year Spanish yield rose through 5.5% and today
ended conveniently at 5.99%.

Friday's U.S. Employment report didn't help. In recent months, employment
had been rising a lot while the Unemployment Rate fell; but on Friday's number,
Unemployment fell due to shrinkage of the Civilian Labor Force despite weak
job growth. That is clearly weaker-than-expected, and disappointing to some
who thought the economy was surging. To my mind, it merely continues a recent
theme of slow, weak, but positive growth. Hardly a growth scare, unless you
were suckered in by the equity market to think there was robust growth.

That happens a lot, especially coming out of recessions. The naturally optimistic
U.S. investor, prodded by the professionally-optimistic Wall Street broker,
sees rising equity prices and assumes that stocks are starting to price good
times ahead. That they are, and the goal of said brokers (and Washington brokers
of the power variety) is to make the perception of good times trigger
the reality of good times as higher prices beget a wealth effect. If
it doesn't happen, you get a scare.

But you can't slap a number on the side of a Prius and call it an IndyCar.
We have a distinctly Prius economy at the moment (actually, it may be more
of a Pinto economy in that it
could burst into flames if tapped lightly).

Perhaps that's the fundamental question at the moment: is this a Prius economy
- not pretty, but it'll get us there - or a Pinto economy - potentially disastrous,
given any provocation.

TIPS voted strongly for the Pinto version, as the yield on the 10-year TIPS
bond fell 7.5bps to -0.26%. That was further than the nominal yield
fell: 10-year nominal Treasuries rallied only 6.5bps to 1.98% (and the reversal
of the breakout to higher yields is complete). The decline in TIPS yields
implies that today's leg of the rally, anyway, was led by declining growth
expectations rather than declining inflation expectations. Indeed, 10-year
inflation expectations actually rose 1bp, while 1-year inflation expectations
declined sharply due to a sharp fall in gasoline prices (also growth-related).

Lower long-term growth expectations and a decline in near-term inflation expectations?
That sounds like the sort of cocktail that would have produced a QE3 rumor
just a week ago! But equities have dropped 4.3% over the last 5 trading days,
with today's 1.7% decline the heaviest-volume day of the five. The 916mm shares
traded would be feeble by any standard except that of 2012, but would you
believe today was the busiest day in the stock market of the year, with the
exception of the March triple-witching and the three month-ends?

Oddly, the dollar was roughly unchanged. If the growth scare is sourced from
Europe but the cold is caught by the U.S., where is the safe haven? Weirdly,
the answer seems to be the Yen, which represents the most over-indebted developed
economy with the worst demographic issues. Go figure, but the buck has fallen
from 84 Yen to 80.7 Yen over the last couple of weeks.

Personally, I think our economy is more of the Prius variety, which has been
my opinion for a while. Europe continues to be a basket case, and I keep repeating
my conviction that it won't be over until
it's over over there (and, unfortunately, before it's over the Yanks may
be coming)! But the U.S. will do fine, as long as you're not looking for a
big expansion. Low growth, and possibly a mild recession, are in our future...and
that's not the worst thing that has ever happened, it just feels like it since
we've been told to expect the equity rally to be validated by subsequent growth.

Equities remain expensive even with the mild selloff. Until a week ago, the
operative analogy for me was the rally in 2010 Q3 following the Bernanke quasi-announcement
of QE2 at Jackson Hole in late August. There was a pullback in that rally
as well - actually a deeper one - after QE2 actually showed up, until the
liquidity gusher pushed stocks higher. The problem is that although we got
the anticipation of the gusher, we didn't get the gusher. And, unless we do,
I think stocks will have difficulty rallying. And if the equity market won't
rally, it very likely will decline.

If (probably when) we actually get QE, then the equity rally will resume getting
over-extended and ahead of itself, thanks again to the naturally optimistic
investor and the professionally-optimistic stock jockey. When that happens,
it will be time to look for the Pinto moment.

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.